The Economics of Past, Current and Future Crises

Economics is a broad discipline that can help us understand the “why” of our world. At its core, the field aims to describe and analyse human behavior in the face of scarce resources. The methods used by economists may be leveraged to explain historical trends and current events, as well as to make predictions about the future.

When applied to the world’s biggest challenges, such as climate change or war, economics has the power to provide insight into possible solutions and strategies to prevent future catastrophe. Sessions at the 7^th Lindau Meeting on Economic Sciences highlighted excellent examples of an economic lens applied to World War I, the climate crisis, and the ongoing war between Russia and Ukraine.

More than a century after its end, World War I remains a struggle for economists to fully understand. Somehow, the leaders of great nations went ahead and made decisions that resulted in one of the deadliest conflicts in history. An estimated 9 million people were killed in combat, and at least 5 million civilians died from military occupation, bombardment, hunger, and disease.

In his lecture ‘Game Theory and the First World War’ on 24 August 2022, Roger B. Myerson outlined how economic theories of games and decisions can be applied to problems in World War I. A deeper understanding of the Great War could hopefully increase the chances of avoiding such disasters in the future. Myerson, who received the 2007 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel “for having laid the foundations for mechanism design theory,” wrote a paper on this topic last year.

“World War I was a monstrous evil. It destroyed human life in vast, unimaginable quantities, and an easy way to explain it is to say that we were led by monsters,” he said. “[In game theory, if] you start by assuming Player 1 is a bloodthirsty monster, then it’s not very hard to explain how terrible bloodletting happens. But to explain how people with normal motivations do so is the real test of a game theoretic model.”

Myerson summarised his thought process when modeling both the onset, duration and end of World War I. The model looked at conflict from the perspective of all sides, while assuming that the actors involved have utility functions and beliefs that appear to make sense. For example, the Germans warned that, if the Russians mobilise against Austria, it will create the situation for a pre-emptive war. Whoever attacks first will destroy the other, in Germany’s view, and so the Germans would have to attack immediately. “In war, even as old incentive problems are resolved, the mobilisation of vast military forces can create new moral-hazard problems that constrain negotiations,” said Myerson, adding that Russia considered the Germans’ warning a bluff and mobilised, effectively launching World War I.

For his lecture, Lars Peter Hansen shifted the conversation at #LINOecon to what the World Health Organisation (WHO) calls “the single biggest health threat facing humanity”: climate change.

The vast majority of climate scientists agree that, due primarily to human activity, average global temperature today is warmer than in pre-industrial times. However, uncertainties still exist in climate economics, such as climate sensitivity (i.e. temperature responses to changes in emissions), environmental tipping points, and the economic and social consequences of climate change.

“Do we act now, or do we wait until we learn more? Often there’s this kind of naïve argument that, since we don’t know everything, maybe we should just wait until we learn more,” said Hansen, who received the Prize in Economic Sciences in 2013 for “empirical analysis of asset prices”. “But it may be very, very costly to wait.”

His lecture on 25 August 2022, titled ‘Confronting Uncertainty in Climate Change and its Ramifications,’ covered his efforts to build quantitative models that can be useful tools for thinking about policy questions related to the climate crisis. His goal is to assess the impact of uncertainty on climate policy outcomes and isolate forms of uncertainty that are most consequential for these outcomes.

“We study how a decision-maker confronts uncertainty in a setting where there will be future information about damage severity, but the value of further empiricism in the near term is limited,” said Hansen. “We apply recent developments in dynamic decision theory to guide how we incorporate uncertainty into policy decisions in this setting.”

For instance, when a planner exhibits some initial caution until the damages are more fully revealed, there is a very pronounced asymmetrical result from the decision-maker, with a small fraction of bullish responses and a clustering of responses that are cautious. Overall, Hansen views this research as an initial step towards exploring more complex dynamic models and the associated uncertainties.

The final event of #LINOecon brought the attendees by boat to Mainau Island for a last event focused on the intersection of science and society. The panel discussion on 27 August 2022 titled ‘Economics and Politics of War and Sanctions’ covered the economic impacts of the ongoing war between Russia and Ukraine, particularly in light of imposed sanctions on Russia by many countries.

Oliver Hart, who received the Nobel Memorial Prize in Economic Sciences in 2016 for “contributions to contract theory,” described how sanctions can be thought of as a form of exit, similar to a consumer boycott. In terms of why a country would impose sanctions on another country, he gives two possible reasons. Using the war in Ukraine as an example, some countries may feel a need to take action against Russia and choose to express their disapproval by imposing sanctions. But ultimately, sanctions serve as an incentive to change the behavior of that country.

“If the whole world would cease to trade with Russia, that would be one thing, but of course, we know in practice, there is leakiness in sanctions,” said Hart. “Some people are going to stop trade or restrict trade, but then there are other countries that are not going to join in, and that can weaken the effectiveness of sanctions.”

He also mentioned that punishing a country with sanctions can actually entrench the current regime rather than causing regime change. Saskia Meuchelböck, a junior economist at the Kiel Institute for the World Economy, added that her colleagues have a working paper in progress investigating the 2014 sanctions against Russia that were implemented in response to the annexation of Crimea. “Those regions that were most affected by the sanctions – those were the ones where support for Putin increased,” she said.

Eric S. Maskin offered his perspective as an expert in bargaining theory, noting that Russia – and Putin, in particular – cares deeply about NATO. The fact that NATO has moved eastward since the fall of the Soviet Union has been viewed by Russia as deeply antagonistic. Maskin believes that membership in NATO for Finland, Sweden, and perhaps even Ukraine should be part of the negotiated settlement as bargaining chips.

“One principle in bargaining theory is that, to reach a mutual beneficial outcome, it’s good to put as many items on the table as possible because that increases chance of agreement,” said Maskin, recipient of the 2007 Prize in Economic Sciences “for having laid the foundations of mechanism design theory”. “One item that I fear may not be put on the table is NATO membership.”

Sir Christopher A. Pissarides spoke about his harrowing experience as a young man in Cyprus at the time of the Turkish invasion. His home country’s instability was the reason he decided to leave and settle outside Cyprus, instead taking up residence in England, where he still lives today.

“I sympathise entirely with what Ukrainians feel in the areas that have been invaded. When you see a great big powerful army firing at [your home] and burning it down… Your father losing his business, your mother desperate not to lose her children – it is something that gives you mental illness, if you are lucky to survive,” said Pissarides. “And then it takes years and years to go back to normal life. What I experienced is very similar in a sense that there was no reason for that invasion.”

Pissarides, recipient of the 2010 Prize in Economic Sciences for the “analysis of markets with search frictions,” also emphasised the importance of actual negotiation rather than just imposing sanction after sanction. He listed other wars in Europe that have occurred in recent history and warned that more will be forthcoming if we don’t start seriously thinking about the consequences of our actions. “We know that if we carry on like this, there’s going to be another war in Europe, inevitably. What are we going to do?” he said. “Are we going to say, ‘They cannot buy our olive oil, and they cannot buy our wines, and we won’t buy their gas’ and hope that will stop the war? It’s just nonsense.”